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Risking Other People's Money: Gambling, Limited Liability, and Optimal Incentives

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  • Alexei Tchistyi

    (Haas School of Business, UC Berkeley)

Abstract

We consider optimal incentive contracts when managers can, in addition to shirking or diverting funds, increase short term profits by putting the firm at risk of a low probability "disaster." To avoid such risk-taking, investors must cede additional rents to the manager. In a dynamic context, however, because managerial rents must be reduced following poor performance to prevent shirking, poorly performing managers will take on disaster risk even under an optimal contract. This risk taking can be mitigated if disaster states can be identified ex-post by paying the manager a large bonus if the firm survives. But even in this case, if performance is sufficiently weak the manager will forfeit eligibility for a bonus, and again take on disaster risk. Our model can explain why suboptimal risk-taking can emerge even when investors are fully rational and managers are compensated optimally.

Suggested Citation

  • Alexei Tchistyi, 2012. "Risking Other People's Money: Gambling, Limited Liability, and Optimal Incentives," 2012 Meeting Papers 1091, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:1091
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    References listed on IDEAS

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    1. Jennifer N. Carpenter, 2000. "Does Option Compensation Increase Managerial Risk Appetite?," Journal of Finance, American Finance Association, vol. 55(5), pages 2311-2331, October.
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    3. Suleyman Basak & Anna Pavlova & Alexander Shapiro, 2007. "Optimal Asset Allocation and Risk Shifting in Money Management," Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1583-1621, 2007 21.
    4. Palomino, Frederic & Prat, Andrea, 2003. " Risk Taking and Optimal Contracts for Money Managers," RAND Journal of Economics, The RAND Corporation, vol. 34(1), pages 113-137, Spring.
    5. Hellwig, Martin F., 2009. "A reconsideration of the Jensen-Meckling model of outside finance," Journal of Financial Intermediation, Elsevier, vol. 18(4), pages 495-525, October.
    6. Guillaume Plantin & Igor Makarov, 2010. "Rewarding Trading Skills Without Inducing Gambling," 2010 Meeting Papers 899, Society for Economic Dynamics.
    7. Peter Diamond, 1998. "Managerial Incentives: On the Near Linearity of Optimal Compensation," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 931-957, October.
    8. Stephen A. Ross, 2004. "Compensation, Incentives, and the Duality of Risk Aversion and Riskiness," Journal of Finance, American Finance Association, vol. 59(1), pages 207-225, February.
    9. Cadenillas, Abel & Cvitanic, Jaksa & Zapatero, Fernando, 2007. "Optimal risk-sharing with effort and project choice," Journal of Economic Theory, Elsevier, vol. 133(1), pages 403-440, March.
    10. Hui Ou-Yang, 2003. "Optimal Contracts in a Continuous-Time Delegated Portfolio Management Problem," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 173-208.
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